Most bank lenders are finding it difficult to negotiate loan fees – borrowers resist both loan origination fees and loan prepayment fees. However, there is a strong case to be made that loan prepayment fees are more important in increasing loan profitability than loan origination fees. Properly structured prepay provisions can help profitability by increasing the expected life of the loan, enhancing credit quality, preventing prepayments in a rising interest rate environment and decreasing margin compression in an increasing interest rate environment.
Further, loan prepayment fees can be easier to sell than loan origination fees if they are properly positioned and the reasoning for including them is clearly explained to customers. If your bank is hedging its fixed rate commercial loans, prepayment protection is mandatory. If your loan is not, then your bank is still exposed to the same optionality, a form of risk.
Options To Consider
There are numerous options for commercial loan prepayment provisions. The table below steps through the most commonly used community bank prepayment provisions. Our findings are that a lockout for the life of the loan offers the greatest protection, but unfortunately, that structure is extremely hard to sell. While most prepayment provisions function as a borrower penalty, and, therefore, are difficult to sell, the yield maintenance provision stands above all others as being the easiest to sell.
Yield Maintenance Protection
The yield maintenance formula is the difference between the rate on the loan and the rate on how that loan would have been priced it was in the market today given the remaining term. Another way to look at it is that it is the present value of remaining loan payments multiplied by the difference between the loan interest rate and the rate on a Treasury note of the same duration.
Yield maintenance presents an equitable tradeoff between lender and borrower, and can properly align the expectations of both. Consider that at CenterState, 20% of 40% of loans used to prepay when we did include prepayment protections in our loans. With yield maintenance, that range is closer to 2% to 6%. In our opinion, the yield maintenance clause may be a perfect prepayment provision, especially in a rising interest rate environment.
Putting This Into Action
The yield maintenance provision can be a better tool than a lockout, a declining balance prepay and much more profitable for a lender than a free option to prepay a loan without any consequences. From the borrower’s perspective, yield maintenance has a sense of fairness and relatively easy to explain. From an economic, marketing and life-time-value perspective, we find the yield maintenance provision an indispensable tool in our commercial loan arsenal.
If you are looking to create a more sellable and a more valuable loan, take a look at this new video below that we put together that steps through the details of a yield maintenance provision. If you are interested in getting the referenced Excel calculator or would like to see a sample of the yield maintenance language that we use, shoot us an email and we will send it out to you.
Submitted by Chris Nichols on September 11, 2017